Wednesday, January 16, 2013

I visited a Herbalife nutrition club in Queens. There is plenty wrong with this company – but this is not a post about the things that are wrong with the company (most of those I will leave for other people to think about). This is simply a post about what I observed and the implications for Bill Ackman's Herbalife thesis.

(a). There are a lot of Herbalife nutrition clubs in Queens. This is an Hispanic area and within the US Herbalife is mainly an Hispanic phenomenon. If you use Google satellite navigation on your phone you will find lots Herbalife clubs (dozens are listed around Corona Queens) though some of the ones you try to locate will not be there any more (suggesting they have either moved or closed).

(b). I was told the best time to visit a nutrition club was between 7 AM and 9 AM so I dutifully arrived at about 7.15. The club was empty. I was told to go with a Spanish speaker because the clubs were pretty close to mono-lingual Spanish. The club was not signposted from the street and coloured paper made opaque the windows so a passer by would not know what was in there.

(c). I was served “all three” meaning an aloe drink, a diet suppressing tea and the protein shake.

(d). This was the first time I had drunk a protein shake. I can tell you they suck - so does the tea for that matter. This stuff tastes unbelievably bad. It is flat-out-gross. I sent an email (with the trusty smart-phone) to a friend in Asia explaining where I was and told him how gross it was. He puzzled: he asked if I was a virgin. He explained that when he was a competitive lightweight rower (he rowed for an Ivy League university) he used to live on protein shakes as he had to keep his weight within the limits. And he exercised extensively on them. Exercise and protein shakes is a well-worn and proven weight loss combination. But they do taste gross. [I have been informed that Herbalife taste slightly better than some protein shakes at the cost of adding some sugars – also I have been informed the texture is much improved by blending in a banana or even a mango....]

(e). There were no visitors prior to 8 AM. By 8 AM I was going to sell my entire Herbalife long and give up on the position. My Spanish translator talked to the guy running the place and he told us roughly how many visitors he got a day and told us the time they came in – and that it really started by about 8 AM.

(f). The translator was correct. The visitors started around 8 and in the next 75 minutes over twenty came in. They came in roughly to his schedule suggesting that they were regulars. They spoke in Spanish and he spoke to them as friends. Most of them were either no longer obese or in the transition from being morbidly obese to (merely) rectangular shaped.

(j). The key product: the proprietor/distributor greeted the visitors as friends and offered moral support as they drank the tea and the shake.

(k). There was a series of before and after photos on the wall. They were impressive – many of the customers – and the husband and wife team that ran the club – had gone from balloon shaped to roughly rectangular. [I gather before and after photos are impressive at other weight-loss groups such as Weight Watchers - however in this case there were a lot of impressive photos for a very small club.]

(l). The husband and wife who ran the shop had been Herbalife customers for about five and a half years and had been running the club for about eighteen months. They were true believers in the product – extolling its virtues and also repeating mostly in Spanish but also in Spanglish the benefits of the Herbalife system. [In their case they also also extolled the virtue of replacing the fat-and-cheeze laden meals that were non Herbalife with something more nutritious and the virtue of some exercise even if it was just walking further.]

(k). The benefits of the Herbalife program in the wife's case were real. The wife had gone from a three insulin shot per day diabetic to a half insulin shot per day diabetic. [Statistically this should add over 15 years to her life expectancy.] Her prior body was balloon shaped.

(l). On the wall was a list of the seventy odd people who regularly attend this Herbalife club. There was a list of gold stars against the names with weight-loss and Herbalife consumption targets on them. Clearly the gold stars were part of the reward system. This looked a little like primary school.

(m). We asked if he had any “downline”. He explained to us that every one of his core customers was also a distributor – and they were a distributor to get the 25 percent discount on stuff they took home.

Observations

This club was not a club selling diet drinks (but it clearly did that). It was a club selling the social support group necessary to drink diet drinks. These diet drinks work (especially when combined with a modicum of exercise). What happens though is that normal people do not have the will-power to maintain a diet drink and exercise regime. My friend in Singapore did – but then he rowed competitively and people into rowing are austere driven people (think all those 4 AM starts).

But I am a fairly disciplined person and - without social support I could not drink these shakes.

In the richer-parts of our society we have a solution to diet-and-exercise will-power problem. We hire a personal trainer (usually someone cheerful, younger and good looking) and they cajole us into weight-loss. This is a “for-hire” personal support group.

But Herbalife is another valid mechanism of getting personal support – and it clearly worked on the customers I saw. Personally I find it very difficult not to endorse a product that reduced to one sixth a person's insulin injection requirement. If Bill Ackman thinks America would be better off without Herbalife he could politely explain that at the woman's funeral.

I will - in the interest of fairness - include the main negative observation: the man who ran this shop covered his rent (we worked that out) but he was cheerful man working hard (80 plus hours a week) and making an amount that was less than minimum wage. I gather than many (possibly a majority) of Herbalife clubs do not cover rent (consistent with the observation that there are lot of Herbalife clubs in Google maps that no longer seem to exist). Minimum wage appears to be the upside.

This showed both the benefit and problems with multi-level marketing. The benefit is that it allows a company (in this case Herbalife) to get deep into a community and that is a necessary part of the product – the product they are selling is community support for weight loss and they can't do that without getting into the community. The problem is that the company actively recruits distributors to the point that it is impossible for the distributors to be good businesses. Indeed as the rewards to many people in the chain are on recruitment (and you can't make it up the chain without a substantial “down-line”) it is likely that recruitment will continue until the distributors make nothing (or less than nothing when convinced to sign up by hard-sell rather than rational argument).

There were so many Herbalife clubs around Queens that I suspect on average the Herbalife shops make something near nothing or less than nothing. The profile of a Ferrari driving Herbalife distributor that Mr Ackman presented was – at least compared to what I saw – ludicrous.

Herbalife is clearly an exploitative system in the Marxist sense. The head-honcho is paid well over $70 million derived from a vast network of people earning minimum wage or less. Dan Loeb (who now controls 8 percent of Herbalife) is someone who often attacks excessive salaries for senior executives. This could become quite amusing.

Some comments on Bill Ackman's thesis

It was striking how totally Bill Ackman's thesis fell apart from observing for just a few hours in a nutrition club.

The best way of analysing Herbalife that I can find is as alcoholics anonymous for fat (and very often Hispanic) people. I joke: “my name is Jose and I am fat”.

Herbalife works in the same way as alcoholics anonymous – by supplying (and in this case selling) a support group to help you kick the “fat addiction”.

Like Alcoholics Anonymous it has millions of members and looks – at least externally – a bit like a cult.

Herbalife like Alcoholics Anonymous has millions of members because it works. It does not work because one nutrition powder is better than another (indeed some nutritionists argue soy based powders are inferior). Herbalife works because of the support group.

AA is probably the single most effective way devised by humanity to cure alcoholics. It is far more effective than any drug developed by pharmaceutical companies and if a drug were devised as effective as and as free of side effects as AA then it would be worth tens of billions of dollars. Even then AA probably fails a majority of times. Herbalife is among the more successful ways of curing morbid obesity (but even then it probably fails a majority of times). [I shudder to think what a weight-loss drug as effective as the Herbalife support system would be worth though - considerably more than Herbalife's market cap.]

The biggest difference that I can see between AA and Herbalife is that Herbalife is (emphatically) a for-profit institution (and possibly quite an exploitative for profit institution) whereas AA is just a club.

Lets run through Ackman's presentation by section

Ackman on Herbalife as a commodity

From Page 21 to 26 of the presentation Bill Ackman “demonstrates” that Herbalife's products are not unique – and from that he argues that they do not maintain their price position by being a “proprietary product”. He compares the product to GNC and other brands and notes the price per serve or the price per calorie is higher.

This is a complete misunderstanding of Herbalife's product. GNC and other brands are sold as commodities. Herbalife is sold with a community support mechanism.

In Central Park anyone can go and have a run. It is free. It costs you $20 an hour if you exercise with a personal trainer. Comparing the price of Herbalife (sold through a network) to the GNC (sold without a network) is like comparing the cost of a run through the park without and with a personal trainer.

Bill Ackman has just missed the point.

Ackman on Herbalife's lack of advertising

From pages 27 to 31 Bill Ackman notes the lack of advertising expense on Herbalife (which he argues is very little) and says that they cannot maintain their price premium that way.

This is of course garbage. Herbalife has the best advertising possible – word of mouth. People will pay huge sums to Facebook for the hope of getting someone to “like” a product online and hence endorse it to their friends. Herbalife has far more powerful advertising support than that – it is deep in the community.

Alcoholics Anonymous has 2 million members and I have never seen an advertisement for the product. However like you I have heard of AA. Brand recognition for community based products is (naturally) very high. I suspect almost every reader of my blog has heard of Alcoholics Anonymous without ever seeing an advertisement.

That said Herbalife does sponsor one of the biggest football teams in the world (Barcelona). It also sponors LA Galaxy but nobody cares about them!

Bill Ackman on Herbalife's research and development

From page 35 to 50 Bill Ackman tells us all about Herbalife's (very thin) research and development program.

He is of course right that relative to its claims Herbalife has a very thin research and development program. So what: Alcoholics Anonymous – relevant to its claims – has a very thin research and development program. And yet it is known to work for a lot of people and the results are well known.

There is plenty of research that says social cues are important in whether you take drugs or not, whether you drink. And social cues are important as to whether you stay fat or not.

Page 164 of the Bill Ackman presentation lays out the key criteria for determining whether Herbalife is illegal. Here is the slide:

I will quote this as it is the core criteria for determining whether Bill Ackman is right:

The critical question for the FTC is whether the revenues that primarily support the commissions paid to all participants are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money-making venture.

Bill Ackman spends most of his presentation arguing that Herbalife's product is the business opportunity. He argues for instance that most the product is sold to "distributors". This was clearly true in the Herbalife club I visited. Almost every customer was also a distributor. They however were clearly customers - they came in - they paid their money - they drank their shake. They look like customers because they were customers.

Bill Ackman calls these distributors victims of a false "business opportunity". Facts on the ground: they are customers.

That fact is very inconvenient for Bill Ackman because if they are customers then Herbalife is legal and Ackman's thesis falls apart totally.

Bill Ackman's logic as to why these distributors could not be customers is disarmingly simple - and amazingly erroneous. Bill Ackman argued that it was illogical for someone to sign up as Herbalife distributor for the 25 percent discount because even with a 25 percent discount the product was more expensive than commodity product available from GNC and other suppliers. [My Spanish translator came back to me with an errata on this point: he says that some of his downstream were considering the business opportunity - but the majority were distributors without any plans at all on the business opportunity.]

That is true. But it misses the point.

Remember those gold stars and the support group. If you buy weight loss shakes from GNC you do not get the gold stars. Buy the product from GNC and you are not part of this Latino self-help group. By not understanding Herbalife as a social support group for weight loss and by analysing the product as a commodity Bill Ackman has failed to observe what globally would add up to millions of customers. Real customers. The customers that make Herbalife legal.

What this story is really about

Herbalife is a company which combines a lot of good (think the life-saved diabetic above) with some pretty ugly features.

But this is not really a story about Herbalife - Herbalife will survive globally. Like all multi-level marketing schemes it will have its ups and downs. There will be all sorts of problems (such as tax compliance throughout the scheme, cash handling, perhaps even using Herbalife accounts to launder money).

What this has (deservedly) become is the story about how Bill Ackman can be so wrong. He spent (by his own admission) a year and a half analysing this company and his thesis can be falsified by visiting a few clubs in his home city. Bill Ackman's thesis is the most easily falsified bear-thesis I have seen from a major hedge fund ever.

You have to wonder how this happened. So I am going to tell you:

Bill Ackman a Harvard educated (magna cum laude) billionaire New York hedge fund manager bet over a billion dollars on a short position (imperilling his fund and his reputation) without checking the facts.

And he did not check the facts because he was so rigid with a misplaced silver spoon that he could not stoop to sit on a subway for thirty minutes and talk with poor people for ninety minutes.

And now an irrelevant side-question. Give me your best guess: What percentage of your non-U.S. readers don't know where or what Queens is? Apart from your readers, what percentage of non-U.S. people with regular access to the internet don't know? Just how hegemonous are we? (I'll guess 2% and 30%.)

What about Ackman's statements about HLF's sales numbers? He said that everything sold to distributors at a discount is assumed to have been resold at full retail price. Therefore their sales numbers are grossly overinflated. And, they treat the distributor allowance as retail profit when most MLM's treat it as an expense. If he's right about that then they should be heavily sanctioned.

JohnThanks for sharing this info. Ive talked to numerous distributors and this is what hlf is about. A Fat Peoples anonymous. The value in Hlf is not the necessarily the product itself, but the service that comes with it. The products eventually get consumed by somebody.

I am asking this question in all seriousness: Given the fact that Bill Ackman is a billionaire (I think), can't he buy a bunch of congressmen to put pressure on the FTC to shut them down or otherwise hurt their business? I know the industry has a large lobbying group, but I can't believe Ackman won't spend a lot of money on "lobbying". I Would appreciate any intelligent responses.

Love your blog and like this post (congrats on your hlf btw, doing pretty well so far), but the attacks on Ackman are a little harsh. If you weren't living in Australia I'd be tempted to think he slept with your wife or personally offended you.

Great post, John. I also wonder if this lack of on-the-ground research will prove to be a big problem with one of Ackman's other big bets: JC Penney. Can guys like Ackman and Ron Johnson really understand how the core JCP customer thinks and makes shopping decisions. Everyone does not fit the mold of a core AAPL loyalist.

Or, conversely, Bill did take the 7-line out to Queens during the US Open this summer, did visit the same HLF 'clubs,' and came away with the impression that less-than-educated people were being taken advantage of for the material gain of HLF's CEO.

If Herbalife didn't "work" in providing effective social support services to improve diet adherence, how would you know? It seems like you are arguing that it works simply because (1) The nutrition club phenomenon exists in the first place, and/or (2) some positive anecdotes exist. But what percentage of Herbalife customers successfully improve their health versus those who attempt it without the costly support services? Similar to AA, mere existence or occasional success does not prove effectiveness. Many women have likewise avoided funerals without using to Herbalife or an analog. Accidental success stories are inevitable. I assume that there are no pictures on the walls on these clubs, or closed clubs, from distributors who left their Herbalife experience with worse health but less money; yet of course they exist.

Without some kind of evidence and comparison, what about these survivorship-bias infected anecdotes rises above mere assertion or tautology? I could open up a psychic shop with no connection to weight loss and run it for a couple of years, then ask all my customers who have lost weight to post pictures -- I would surely get some. And if I was a psychic who only admitted people who wanted to lose weight, I would have even more pictures.

Sample size is a bit small there, champ. While I'll concede you've been right thus far, you're being foolish if you think Billy boy doesn't have an ace in the hole. Further, you really think this man spent all this time and money and didn't think to at least send someone to a club to chk it out? Perhaps his findings (I'd assume he went to more than one) were just completely dif than yours.

The trouble here lies in the completely subjective nature of this blog post. Like it or not, Ackman's presentation was largely objective and raised several legitimate questions with regard to the business model and accounting practices of the company. Its great that a few Latino's are benefiting from Herbalife, but do not loose sight of the fact that millions of other people have lost significant amounts of money here, and that the company has a very troubling lack of transparency in this regard despite claiming otherwise. We're not done hearing from Ackman on this one. This feud is just getting started.

The puzzling thing then is, why doesn't anyone start a nutrition club chain based on existing shakes and a regular franchise business model? They should be able to beat herbalife on prices and income for the franchisees, without all the MLM/cult crap dead weight.

This is a great addition to the debate, but I think that Ackman's key mistake is actually on his slide 122, where he says: "We believe the majority of Herbalife's So-Called 'Discount Buyers' are, in fact, failed distributors." He then does what seems like an incomplete job on how he gets to that conclusion.

He seems to argue that since HLF won't disclose how much of revenue is external, it must be internal (which is fine), but that internal revenue means a failed distributor. Either I am misunderstanding his point (likely) or he makes a logical jump there... John does a good job of showing how internal sales are just fine, they are merely customers buying at a discount and being labeled distributors.

I would posit this: the majority of the low-level distributors are indeed merely customers, as John lays out clearly. However, there are almost certainly some proportion of failed distributors, as there is in any MLM company. Neither Ackman nor John seem to size up how many distributors fall into each of these two buckets.

My thesis would be that the huge majority of merely customers, and that, at most, HLF may need to change some of the labels and recruitment styles it uses for distributors... namely, call customers "customers" and charge them the intro fee like COST, and have higher level distributors essentially operate as they do now. I don't see why that would meaningfully change the business model.

"By 8 AM I was going to sell my entire Herbalife long and give up on the position."

So, after 45 minutes of field research you were on the verge of reversing your entire thesis? Doesn't sound like a very convincing thesis at all if your opinion can be changed with something that trivial.

Chances are, if you are rich and use a personal trainer, he or she will recommend AdvoCare nutrition, which is another direct sales company; it has a stellar reputation and quite an extensive product line.

Ironically, AdvoCare was started in the early '90's by Charlie Ragus, who was a very successful Herbalife distributor during the 80's.

The worst that will happen is a public revenue correction and some corporate housekeeping to align with any FTC concerns.

Should any lawsuits begin, the discovery will bring forth a lot of information; but it will take a long time, and cost a lot of money.

Direct Sales is a huge industry, and HLF is a major player. It may get smaller, or be taken private, but the share price won't go to $0.

John I like your blog and have shorted some of the same stocks you have, sometimes based on your reasoning, but you went to ONE club, spent maybe two hours there and cracked the billion dollar case? Seems hard to believe that this "research" satisfied your usually rigorous standards. Sample size isn't everything, but anyone who has researched Chinese small caps (as I know you have) understands that sample size is important. For any Chinese company, you can usually find one plant that seems busy for one day. But that doesn't make the company legitimate or profitable, does it?

Would be interesting if someone were to put a 1000 slide presentation together on how much $ (taxpayers' as well as consumers') is saved by the many formerly obese people who lost weight due to Herbalife. Lower healthcare costs seem like a net positive for consumers, and society.

I wonder how that weighs (pun intended) against the alleged costs/losses that distributors bear, according to Pershing Square.

Also, how are the losses that some of the distributors bear, any different from the losses that entrepreneurs in general bear...

Pershing Square seems to be walking a fine line here, from a moral hazard perspective.

I love the blog but I think you have missed some of the main points of the Pershing argument.

1 - why would you sign up to be a distributor and pay money just to get a 25% discount if you can buy Herbalife products on eBay for at least a 30% discount?People are signing up to be distributors in the hope of becoming rich. It is a pyramid scheme because someone down the chain ends up with stock they cannot sell while 73$ of the purchase price is with the upper echelons of the pyramid

You have to remember that you don't actually pay money to sample products at the health clubs and you can only try 3 different products.

To make any money you have to recruit members. For them to make money, they have to recruit more members - that my friends, is a pyramid scheme

But then I thought… here’s a business where the majority of distributors don’t cover rent. And one of the more successful distributors has a better job than, you know, illegal sweatshop work. So, what kind of multiple are you putting on those earnings?

I think the one thing that Ackman has highlighted which your unannounced site tour really does not address is the pop and drop issue. By your account the site tour was to a Hispanic club, which is clearly described as being in the pop phase in Ackman's thesis. I thought one of the larger arguments in Ackman's thesis is that Herbalife is running out of markets to pop in order to offset sharp drops elsewhere. It would have been probably far more appropriate for you to visit a club within a white area of New York in order to invalidate his thesis.

So let me get this straight you discredit Ackman's arguments by agreeing and actually providing evidence that just about the only people buying product are the distributers and the try to rationalize why this is O.K.?

Good luck with your long position, your going to need it. I did watch Ackman's whole presentation including the parts noting that the FTC considers businesses that sell to themselves illegal pyramid schemes. None the less it only took a couple of minutes at the outset describing a compensation plan that was clearly designed to ensure 95% of the population would get a headache and give up trying to understand it to convince me HLF is a pyramid scheme.

You can rationalize all you want about how the dupes selling the product to themselves is not a pyramid scheme when it cleary is and is defined so by the FTC. If they don't wake up and do something about this Ackman will shame Congress into doing something about it. HLF is toast.

It is ironic, but your post actually legitimizes the short position here. Your discovery is that Herbalife products suck (everyone knows that), and nearly all the distributors who sell Herbalife basically make no money whatsover (also a known fact). How is this a sustainable business model? It is not. Moreover, after your description, how can any person with a shred of morals invest in this type of company, which is blatantly taking advantage of the poor and uneducated?

A company, like Herbalife, whose product does not work as advertised, and whose distributors do not make money, cannot survive unless it continues to find a greater fools. Eventually the fools run out. This is the basic definition of a pyramid scheme, whether the FTC steps in or not.

John,I am a keen follower of your blog however, this post (and the preceding posts relating to Herbalife) have been a very disappointing departure from your normally insightful and entertaining posts. Unfortunately, to any neutral observer your anecdotal “evidence” and observations don’t really stack up and answer the most damning questions that came out of by Bill Ackman’s detailed analysis. I cannot understand why you have addressed many of the “soft” issues raised in Ackman’s presentation (I hesitate to say “addressed” as I don’t that visiting one nutrition club and hearing a couple of stories passes as rigorous analysis) but you have not even begun to scratch the surface of his core thesis that the company compensates distributors primarily for recruiting other distributors.Where is your discussion about the inflated “retail sales” figure reported by the company and used in their 73% payout ratio calculation? What about the wholesale commissions classified as distributor discounts? Where should these sit and how can we know this without understanding the motivation of the distributor who purchases the product?What about the recruiting rewards alleged to be buried in SG&A? And finally, what are your views on the inconsistent and misleading responses from the company? Their initial reaction was to attack Ackman, not provide any evidence refuting his claims. Their analyst presentation did not directly address the split of compensation based on recruiting vs actual selling. Why didn’t their response contain a detailed calculation of the split between recruiting based and sales based compensation? Should we not also be suspicious of the fact that the company claimed not to track where its sales went, then claimed that a large portion were consumed by distributors and then finally proclaimed that ~90% of the product is sold outside the network of distributors?Regardless of who you believe in this situation it is clearly complicated enough and there are enough red flags to warrant a thorough and detailed analysis of the facts (which hopefully the SEC are currently doing given the reports of their probe into the company), not just a visit to Queens.

Great post John. Ackman comparing Herbalife to GNC reminds me of Einhorn comparing Chipotle to Taco Bell. Until he has used the product and understood its users, it is easy to misunderstand the attraction.

This piece is so shoddy that you couldnt make a better case for Ackman's argument.

- You sampled ONE club and consider yourself an expert. By your own admission IF the club was empty at 8 PM you would sell. What about the run down clubs that Ackman displayed with no people within?. -Furthermore how do you know Ackman hasnt been to a live club?

- The club owners cant even make rent and less than minimum wage. And this is the poorest segment of American society. If this isnt exploitative ( and illegal) what is?

- Everybody and their mother understands this "social networked weight loss pitch". Where are your numbers on A> how many distributors quit B> how much of HLF revenue is from internal consumption etc.

Your moral justifications are quite laughable. You want to help the poor in america - invest in the new weight loss drugs, give to the innumerable charitable organizations fighting childhood obsesity etc etc.

The more I think about it, the more I am convinced that the legal (SEC/FTC) angle of Ackman's short thesis was never his true focus. It's a smokescreen.

Rather, I think he is focused on attacking the one good thing this company has going for it; its financials. If through a media campaign he could increase the mortality rate of HLF distributors (which is already high) and slow or prevent new customers from joining the system, the earnings engine of the company would be destroyed. There are parallels to your comments on social media/Alan Jones campaigns here! This is one of those "Together we can change the world for the better" stories. The legal angle is just another facet of the media campaign.

Ackman had claimed on television that customers and distributors were already walking away from Herbalife. I don't think this is true, or at least not to the extent that he claims. So it appears that his media campaign has failed.

I'm convinced he never expected the SEC/FTC to act quickly. This is why we all scratch our heads at his reliance on the J-Factor (judge factor), perhaps while sipping a Herbalife shake!

I suspect ackman hoovered up deep out the money call options for months before he put on his short. So even if he gets massively short squeezed, he will survive being hugely wrong. John is wrong about him imperiling his firm- he has an out

john - those same people are JCP shoppers. PLEASE go to JCP and talk to some people about how it is not a good place to shop anymore. I have done the same and can assure you, you will reach a similar conclusion

- The retail sales figures - not a great thing but it is clearly stated that product sales are the confirmed sales from HLF to it's distributors. I can ensure everyone that the commission structure to distributors are based solely from the product sales figures. It could be a way to illustrate the earnings opportunity for the distributors to talk about the retail sales margin in an "earnings scenario" but it is not assumed in the books for sure.

- Commissions have two parts - one is the "product discount" which is acheived in different steps according to their plan and paid to all. The other one one is straight forward "bonuses" or "sales commissions" and is paid only to the sales leaders of different levels. This is cleared by big4 accountants in virtually all MLM companies US/Europe.

- Some recruit rewards in SG&A - most likely the conference costs are there, for example paying for rent, hotel, food, artists etc at their various large events. If you think that it is a direct "recruitment compensation" then ok. Big4 accountants and FTC do not think so. Most companies pays commissions to distributors on one P&L line item and pay for the motivation trip on the other, under SG&A.

- Tracking of final sales - This communication story is really unfortunate and unprofessional and I think HLF are killing themselves for this. If you as MLM company start including it in your reports (as HLF did and stopped doing, hence the Einhorn call), you should keep doing it and discipline your communication. (that 90% figure was thrown out from a pressured CEO in a hot time and live, it could happen to anyone but it shouldn't). Anyhow, it has been establishe well enough by their updated research that they have decent sales outside the network and anyhow I believe from recent debate there is a different view now on internal consumption like described in Mr Hemptons visit and reasoning.

I am going to bet that silver spoon bearing Mr Ackman has also never been more than a pound or two over healthy weight in his entire life, thanks to a comfortable upbringing. Rich people can afford to eat good healthy food. Thus he wont have an appreciation for the value of the support group in losing weight.

Speaking as a fat white Australian man who lost over 25kg on a similar product made by Nestle (optifast) I can tell you it is damn hard without support. In my case is was well off middle class white guy support though - one to one with a paid exercise physiologist.

I've also been to Weight watchers - where you pay for the support group. That could give you some interesting numbers on the "value" people are willing to put on the support group.

You stated all of the "customers" were also Herbalife distributors in order to get a 25% discount. How many of them were personally sponsored by the store owners, and how many were sponsored in depth, by others who also visited? Until you know the answer, you have proven NOTHING.

Bill Ackman a Harvard educated (magna cum laude) billionaire New York hedge fund manager bet over a billion dollars on a short position (imperilling his fund and his reputation) without checking the facts.

And he did not check the facts because he was so rigid with a misplaced silver spoon that he could not stoop to sit on a subway for thirty minutes and talk with poor people for ninety minutes."

While your nutrition club visit is interesting, it's usefulness in helping determine if Herbalife is a pyramid is about zero. Just like the successful distributor stories that Herbalife uses to open nearly every one of their meetings is valueless in determining the probability someone can earn money in Herbalife. One of their top people gets up and tells their rags to riches story, and then says "I now make $80,000 a month in Herbalife!" (You can find these meetings all over YouTube).

Do they in fact make $80,000 a month from Herbalife? Yep, probably. But is that income representative of what the average distributor can make once all the data on distributor income is pooled and then analyzed? NOPE. The pooled and analyzed data show 84% of Herbalife distributors make a median income of less than $500.

That's the difference between using anecdotal stories and data to make a determination about what is really happening. And while the specific data needed to make the pyramid determination isn't available because Herbalife doesn't collect it (gee, wonder why?), Ackman is a lot closer to using data that can be found to make that call than you are.

Just a heads up, there is a weight loss drug more effective than Herbalife's support system: Ephedrine and Caffeine. The problem is that within the USA it is banned largely due to the fact that ephedrine can be used as a feedstock for methamphetamines.

en.wikipedia.org/wiki/ECA_stack

Under standard fat loss dosages it is very effective and safe assuming you are being monitored by a doctor and have no prior conditions.

Ackman never has said 1 word criticizing the product. The fact people are losing weight is not a real surprise because HLF sells real weight loss products and Ackman recognizes this. However he argues there is no premium or proprietary inputs. This leads to the next point of justifying such high prices over market competitors. Then comes the MLM and the real question: who is buying all these products and how can this company's model be sustainable? Ackman's assertion is that HLF's multilevel marketing is in fact, a pyramid scheme.

By the way you could run a pyramid scheme with ferrarris or ipods. It is a question of sales and distribution, not the quality of the product.

@Anon with the call options cover theory: not only did Ackman say he hasn't done that, but you can check yourself in a few clicks: the open interest is free public information (see theocc.com): there are currently about 36k call contracts open with the strike >50 (for all dates), that would only cover 3M shares even if Ackman owned all of them. Really deep out of the money (compared to his presumed entry) numbers are negligible.

For the people you met - yes, I suppose the product is useful. But the Ackman thesis is that this is a pyramid and it requires exponential growth to stop it failing. The profits of the corporation are founded on selling the idea to wannabe ditributors (suckers) that they'll turn from rags to riches. They wont sell that lie by advertising what you witnessed - a successful support group run by someone only just able to cover the rent. And that was at a club in the heart of an area full of the target consumers.

I don't understand the logic behind the criticism that e.g. 84% of distributors make less than $500 a month. As I recall, similar figures apply to real estate agents (not absolute amounts, but relative to the top owners) - the vast majority make very little, but that doesn't invalidate the model.

I think this relationship is a fairly common power-law relationship that comes up in a number of industries. Note I'm _not_ making a direct analogy or calling real estate agent relationship a pyramid scheme, just noting this figure tells us nothing.

If, however, people work as distributors (real estate agents) for a variety of reasons apart from pure compensation (part time work, 'lottery ticket' chance of doing very well, social reasons, discounts, etc), the model might well be sustainable. Distributors may 'join' on the hope of great rewards, but remain at minimal compensation for other reasons (and cost of remaining a distributor is sufficiently low). As long as those leaving because they're unsatisfied with compensation are replaced by new distributors, there's no substantive issue.

Getting back to Ackman's overall thesis: I don't think one has to agree 100% with John's approach, sampling, methods, etc, and yet still buy the part of his analysis that says Ackman's claim that this will go to zero appears wrong. The 'go to zero' claim looks to be dependent on it being declared an illegal pyramid scheme, which is at best a modest probability.

John you are a champ and many of the political correctness police mistake your brief, at times brash Australian summation of this situation for a lack of research or analysis on your part.

Well done for saying things how they are, sure you may only have seen one health club but it is 100% more than Ackman and he is the one who gambled so much of his LP's cash.

As an aside, from the solution to obesity and propensity for hispanic usage, maybe Obama should sell down the US Gov stake in $GM and take $HLF private thereby reducing obesity costs to Medicare and achieving at least some tax revenue from illegal immigrants?

Well done for speaking your mind in the public forum, it is so refreshing given the number of shills espousing complete rot on a daily basis.

When Ackman puts out an investment thesis, you have to take notice. That having been said, he has been spotty over time. I think he knows real estate inside-out and has generally done very well on that side of things (think General Growth), but in terms of other businesses I don't know that he is that outstanding (think Target, JCP). Einhorn is probably better on straight businesses and there is a reason why he hasn't jumped on this from the short side.

If you are correct in you assessment then HLF is being held down by Ackman's huge short position (and attempt to bully the market with public comments) and the FTCs investigation. If/when the FTC announces the all clear, this stock will have a monster short covering rally (think COF in 2003).

Thank you for your Herbalife comments. I find the whole debate fascinating. I agree with you that Ackman's belief that the gov't will now step in on Herbalife is misguided. I however agree with Ackman and others that the people selling this are not making money, the product is not unique and the money being made is by selling more franchises, not in how much herbalife product is being sold. That the buyers are calling themselves sellers speak to that.

I will excuse my ignorance but have followed this a lot and can not find an answer; what is the most likely scenario for how Ackman have shorted this significant share of the float, technically? Does a hedgie broker an OTC deal with 1 broker or do they use several different? Are there usually time limits or can the hedgie just keep rolling the short infinite? Are the shares being lent by the big funds that are long HLF? Maybe this is irrelevant for the share price development but there seems to be very knowledgable readers on this blog. (im long hlf)

AllI want to figure out is why now? If the company is that illegal and a pyramid scheme etc etc why has it been listed on the stock market in the first place, aren't there specific terms & conditions for being able to be listed in the first place, where have the official authorities of the government been? in a comma? Why have they not shut the company down years ago, if this is such a pyramid shceme and a lot of people are getting hurt and financially parralised? Ackman is there to manipulate Herbalife and make more money that is for sure. What does he want to do with this money or any money, take it with him when he dies! believe me you come in this world naked and go out of of this world naked too! Bloody stupid the lot of them. Juliet.

And I agree that HLF will not go to zero. I don't think the SEC will take action and I don't think Ackman has any chance at influencing distributors (does anyone really trust a short-selling hedge fund manager? especially people from lower income brackets?)

But this is your worst post of all time. It is terrible on so many levels.

First, you are unfair to Ackman

You claim:

"And he did not check the facts because he was so rigid with a misplaced silver spoon that he could not stoop to sit on a subway for thirty minutes and talk with poor people for ninety minutes."

Yet from page 270 of the Ackman report, and I quote:

"We sent a Pershing Square team member to Queens, NY and Omaha, NE to research nutrition clubs. What follows are photos of nutrition clubs we visited..."

Followed by 12 photos, including 2 from the inside.

Secondly, you draw some really bizarre conclusions

You visited one of the most successful nutrition clubs, observed 20 customers during a morning rush hour, and concluded that because there are real consumers of Herbalife products, it isn't a pyramid.

Of COURSE Herbalife has some real consumers. They have revenue of almost 3.5 Billion.

You visited one of the most successful clubs, which by definition means it has customers...

And yet, as good as he is, that guy is making less than minimum wage.

And what do you think all the closed nutrition clubs are?

Answer... failed distributors.

The company forces you to recruit new distributors. They make it virtually impossible to sell retail by insisting on no signage, styrofoam cups, and blocked windows.

Or as you said yourself, "The problem is that the company actively recruits distributors to the point that it is impossible for the distributors to be good businesses"

It's not Herbalife that is selling the support groups

Support groups ARE great for weight loss.

But it is not Herbalife that is selling the support group idea.

If they were, they would encourage customers to join nutrition clubs, instead of making them become distributors.

If they were, they would encourage you to run the nutrition clubs so that walk ins would be welcome.

No, what you found John was a "successful" (relatively) distributor. And he was successful because HE, despite all of the hurdles put in place by Herbalife, was able to create an effective support group, complete with friendship, before and after photos, and those fancy stars.

I have a problem with your analogy to AA. Alcoholics Anonymous is a spiritual program without profit motive by anyone who follows the 12 Traditions. Perhaps HLF has self help aspects, but your analogy suggests you are both unfamiliar with AA and after an hour or two in a shop, barely familiar with HLF. BTW, the story about the insulin user could have been nothing more than a sales story.

The problem with Mr. Hempton's conclusion is... Nutrition clubs was started in 2003 as sort of "demo party" by distributors in Mexico. It was NOT a corporate sanctioned sales method until it spread back to the US a few years later.

If we accept that Herbalife's main value is in the social support system that these nutrition clubs provide, then what was Herbalife doing for the 23 years PRIOR to 2003?

I am not sure whether Bill Ackman is right but I don't think you have provided any substantial argument for going long on this either. To me, given what the situation is, I would just stay out of this rather than take a long position on it, given that you yourself admit they are kind of schumbags.

Your research and arguments are very simple and likely to justify your already rigid thoughts, which you have to stick to given you have already announced them on the TV.

Great that you are impressed with AA style concept for fat reduction? But have you ever been to a gym? AA is by the way a movement and its independent, you can't compare that with Herballife clubs which are trying to sell their own product.

You are saying the GNC and Herballife are commodities. 100% true. But so are the stories about insulin shots, weights, before and after. Its nothing new, everyone is trying to do that. Ask your rower buddy about his preferred brand of protein shake? And ask how did he make that decision? I change my protein shake every time I go, depending on the price.

Protein shake really works, but as a dietary supplement not as a replacement. If you exercise enough, they help you burn fat and replace that with protein shake. How did these guys loose weight by just drinking protein shakes? These clubs teach people to replace their food with protein shake to get skinnier. maybe you should do some research on how risky it is. All drink come with a warning that it should not be used as a replacement.

A person who takes protein shake looses weight?? That would be magical. Protein shake work only for people who exercise a lot and rebalance their body by replacing fat with protein or else you are just putting yourself at a huge risk by having this seriously unbalanced diet.

"guy these things work!" your simplistic drive by and observations are not impressive either.

One mistake in Ackman's presentation was that he compared prices on a per calorie basis. Any person who looks to compare price for protein drink, would do that on (a) price/protein and (b) price/calorie , You need high protein and lowe calories for the same serving

The bigger issue here is that shorting of stocks is, legal. In addition, anyone can make a bet shorting a company, then completely defame a company in the press with the sole objective to profit when the stock tanks, whether the defamation is true or not.Shorting should be banned. Why should anyone profit on a company that is not successful. The price will reflect a company that fails in their operations on its own by investors that will sell. Ackman, like the entire investment community that operate in the shorting world are prime reasons why millions of americans hold trillions of dollars in cash and won't invest in the equity markets.

@anonymous January 19, 2013 at 6:10 AM asked>>Does a hedgie broker an OTC deal with 1 broker or >do they use several different?

typically your Prime Broker does this for you most of them have a profitable sec-lending team.

>Are there usually time limits or can the hedgie just >keep rolling the short infinite?

nope but the borrow can cost more or less depending on demand and your relationship!

>Are the shares being lent by the big funds that are >long HLF

Could well be it could even be shares that you hold in your account that you agreed to lend when you signed up to trade in a retail account.. the actual process of a locate and sec lending is a bit more complex..

You think it's logical to conclude that the majority of HLF distributors sign up to get the 25% discount and consumed as a "customer" .

But pray tell, all MLM gave product discounts to distributors, and of course all distributors would consume the product themselves, at various consumption level.

So if you start using "excuses" like HLF to qualify the Distributors as Customers, then you really take away the defining line of differentiating a legitimate MLM from a Pyramid. This is the hallmark of Pyramic enablers to blur the laws, as wolf in sheep skin.

I found that a former boss of mine whose company went bankrupt a while ago is into it and owning a Herbalife Health Club these days. Its nicely furbished in a pretty good location on a traditional 2nd tier shopping street here in the capital city of our small and prosperous country in the heart of Europe. Since he is a decent salesman I figure he has his little distributors network set up by now. His webpage is well made, with a lot of before-after pictures (including himself although he was never fat). He also runs weight-losing competitions including price money in various communities - not sure if this is part of Herbalife or his own endevour.

Personally, I disagree with the point that the higher price for Herbalife products can be justified by the community of the Health Clubs since Herbalife doesnt contribute anything to these clubs that might validate the premium price (see the number of close down Health Clubs you found in Queens). Basically you could do the same with cheaper (but equally good) products and without having to help build up the pyramid further...

Herbalife may well be a scam, but Ackman's preso was lame, far beneath Pershing standards.

- Commodity products can have high margins IF YOU CONTROL THE CHANNEL. HLF has no competitors at its point of sale.

- Ackman, a US-born billionaire, has never personally seen it sold or advertised because it moves by word of mouth among low-income immigrants.

- Pershing's hatchet-job website cites research by Barry Minkow, who is currently in federal prison for securities fraud, in which he created false allegations against another public company to aid a bear raid.

All three of these elicit a bewildered, "duh." Even if he proves right, the process was bad, which says bad things about Pershing.

Sheez, that last sentence got me. To accuse somebody else of being stuck-up and rich, while writing such an extensively condescending article. If any of the Hispanics that you so freely wrote about could read/write English and understand how you were calling them "balloon-shaped" and analyzing/taking apart their actions, businesses, and community...it's insulting. I don't think you'd like it if somebody richer than you showed up at a meeting of you and your friends, went home, and then wrote in detail about you as if you were guinea pigs in a cage. Especially private financial things like: "Hey, Bobby works like a dog but barely makes minimum wage!"

You accuse Ackman of not having the noblesse oblige to talk to poor people for 90 minutes...you talked to poor people for 90 minutes and felt entitled to write a long treatise based on them. That's just as arrogant, entitled, and again, condescending, in my book.

I am constantly amazed by the things I learn from your show, but for the first time one of the subjects hit home more directly than I'd expected. I have been using Herbalife products for about a year and I had NO IDEA that it could be a Ponzi scheme.

I am just a regular customer. I have a distributor in California who I met in an online knitting forum. We both also play roller derby. Herbalife is pretty big in the roller derby community because they help sponsor a fitness/nutrition challenge (called Derbalife). The Herbalife products are not at all required for the challenge, but of course they are glad to educate us about them if we want to try them out.

So, if you are wondering who the Herbalife customers are — a bunch of them are rollergirls. The shakes are great and if the company goes under because of this short-selling nonsense then I am totally going to go knock that guy down.

First, you, through a thin veil, attack Bruce Berkowitz on lacking common risk management skills by having large exposure to the financials. To his defense, he is a successful deep value manager. For him, risk is related to (mostly) AIG's discount to book value and improving fundamentals, not the volatility of the stock. Given his fantastic track record and decades of knowledge in the financial/insurance sectors, I would give him the benefit of doubt.

Second, your analysis on HLF is interesting but really no need to personally attack Ackman. Its kind of ironic you go on CNBC and say HLF is a "scumbag company" but you wouldn't short it. And then you make a post after visiting a HLF club saying how it improves people's lives. So would you tell the spouse of the obese person who would have otherwise died that HLF is a scumbag company too at the hypothetical funeral? C'mon now.

The problem is this.. they are not franchises, so you will NOT get the same quality service at every Herbalife Nutritional Club! You visited one place! Just like all Mexican restaurants in the city of Chicago, you're gonna get a different taco at every place.

At 1722 W. Chicago Ave. they serve on an average 50-60 people per day. The place is really nice! A true example of what Herbalife would love every nutritional club to be.

Ah, how quickly people forget. Remember when Ackman was short MBIA and was ridiculed by the "experts"? Of course he ain't no saint, and he could be wrong, but I wouldn't be surprised at all if 5 years from now he has the last laugh...

Problem I've seen is misinterpretation of what Herbalife is. Nutrition Clubs can be "registered" by any independent Herbalife Distributor with Herbalife. However, there is no specific requirement such as having certification as a nutritionist, etc. It is simply stating that an Herbalife independent distributor is using his/her home to hold "nutrition" gatherings with potential customers, or existing customers to help them with product selection, and help them reach their goals. Is that not a good thing? Some people need the help. Some distributors make a bad name for the company though, not because of the nutrition part, but rather being greedy and using tactics to promote which are sometimes questionable.. such as putting leaflets on everyone's car at a shopping center. Herbalife is a good company. Distributors are in fact independent...so blame the bad ones, not the company.

I disagree. I took the products without any support group, by my self at my house, and lost 50Lbs and regained lots of energy at age 22. Have you checked the doctors and scientists that work behind these products? Just to mention a nobel prize winner, louis ignarro and americas best doctor, david heber. Think about that.

I'm a big fan, but I disagree with this one (disclosure: I'm short HLF).

Herbalife markets itself as a business opportunity, not as an AA for weight loss. If they did, wouldn't they be generating a similar amount of revenues as AA?

Perhaps more b/c they would cross sell their nutritional products, but I don't see why regulators wouldn't shut them down unless they made changes to their marketing tactics... which would kill the value of the stock. The bulk of their business model is dependent on a pyramid scheme. Wouldn't these support groups be better off without Herbalife? They could then use equivalent products that are cheaper and not have to pay to be a "distributor." If you go to the FAQ section of the website (or any other for that matter), there is nothing on setting up a community support group, but there is plenty on how to become a distributor...

This is based on a quick analysis so apologies if I'm missing something big here.

Great Post.As far as the nutrition club debate..here are MY numbers. I took over an existing club that was going to close because the previous owners didn't know what they were doing. This was Jan 2013. Within 90 days I had the debts clear and the club has covered its own expenses and often a little more. Yes, a part of my daily (regular) customers are discount members (ie distributors). We offer free fit camps, meal plans, wellness Evals, and a support system. They get their daily services (shake, tea, aloe), and YES a hug, a pat on the back, and support. They are also using OTHER products like Skincare, the unbelievable sports supplement line, heart line, etc. I also have customers that pay retail off my shelf or order and we ship to them. My first year numbers are over $100,000 sales running through the club (cash or on the square) and my total org volume was over 300,000 points. The issue with the whole 'internal consumption' thing is that these products are purchased by ME then sold in the club or to a customer. Herbalife does not track this because we are INDEPENDENT DISTRIBUTORS and are issued a 1099. Now, IF Herbalife, the govt, or the SEC or FTC needed me to, I have sales slips, receipts, electronic sales logs, as well as personal info on all my customers. Ackerman bet big, and he will lose because he does not fully understand. As far as the products being of little or no value and overpriced, My wall and my club, and my FAMILy are full of stories of lives being changed.....Herbalife doesn't cure anything, but the NUTRITION that it gives our bodies allow them to function better and repair ourselves. I have 3 current facilities in my organization, and plans to open 3-4 in the next 18months. And, Mr. Blogger, if you got a nasty shake, you went to the wrong place...drop in anytime.

If the nutrition clubs have REAL customers AND the overall volume is at least half REAL customers, they do change whether HLF is an illegal pyramid. The above is the DEFINITION of an illegal pyramid. However, HLF operates very much like Amway, the world's largest MLM scam, click on my name for the details.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.